Where evidence meets policy

Unlock growth and prosperity with the productivity key

As the pre-election dust-ups over who has the best strategy to get the economy back on course get into full swing, what is the real story about how people’s incomes and living standards have been affected in recent years? Professor Sir Richard Blundell unpicks the evidence around who has been hit hardest over time, what lies ahead for them in a climate of continued belt tightening and points to the key areas for policy focus.

Photo credit: Julie Kertesz

In contrast to previous recessions, the recent recession in the UK saw real wages fall strongly with very little sign of subsequent growth. Productivity has also been extremely slow to pick up. However, overall employment has remained fairly buoyant.

The evidence points to persistent changes in living standards, especially at the lower end, with longer-term earnings growth coming mostly from high-skilled occupations. Even among low earners the impact of the recession has not been even handed, with the earnings of young adults being particularly badly hit.

These trends put extra strain on the welfare benefit system, as more years of economic belt-tightening are promised with the prospect of further benefit cuts. For those at the bottom, incomes will very likely only be maintained through increases in family labour supply and through the benefit and tax-credit system.

Jobs and productivity

Many of the key determinants in the trends in inequality and in overall living standards over the past 25 years in the UK, including since the financial crisis, have been driven by changes in the labour market. For example, the UK has seen a huge increase in those with at least a BA degree since the early 1990s with hardly any fall in the graduate premium (the additional amount of money a graduate is expected to earn over his or her lifetime compared with a non graduate).

Coupled with this has been a large rise in the share of earnings by those at the top end of the wage spectrum. More recently there has been the dramatic fall in real wages across the board since 2008, to which we can add changes in savings and asset prices, in particular housing; and reforms to taxes and welfare benefits.

Whatever measure of earnings is used, Figure 1 shows average real earnings fell back strongly soon after the onset of the recession. This is evident even after adjusting for hours worked and occurred even though workforce composition shifted towards more productive types. Moreover, individuals faced real wage falls, with unprecedentedly high proportions of employees effectively experiencing a nominal wage freeze.

‘Effective’ labour supply was higher than during previous recessions, with some of the increase in employment attributable to policy changes. Labour supply has increased among lone parents as a result of job search conditions attached to benefit claims. Older workers are retiring later as a result of the increased State Pension Age (SPA) for women.

Productivity has been stagnant with little or no growth since 2008. When measured as output per hour, it remained below the 2008 level throughout 2014.

Widespread inequality

In many countries, including the UK and the US, the inequality of earnings, after a few decades following World War II increased considerably. In the UK, the increase in inequality in the 1980s and early 1990s was widespread: inequality increased within and across education groups, occupations, cohorts. There was a particularly strong increase in inequality for all measures during the 1979 to 1991 period.

However, since the mid 1990s, there has been little change in income inequality in the UK over much of the income distribution. In glaring contrast, the incomes of the most wealthy have grown at a considerably higher rate than the average household.

While top incomes have grown rapidly, the welfare benefit system in the UK has had to do increasingly more work to maintain the incomes of individuals and families with low earnings.

In this recession the fall in consumer spending has been deeper than in previous recessions, with consumption per head still 4% below pre-recession levels at the end of 2014.

As shown in Figure 2, unusually expenditure on consumer nondurables has fallen most. This is especially the case among the young and to some extent among the middle aged. Saving ratios are lower than during the early 1980s and early 1990s but haven risen since 2008 (and pension contributions are higher). The consumption data points to an expectation of a permanent fall in living standards, especially among the young and middle-aged.

Figure 2: Non-durable spending per capita across UK recessions

Source: Crossley, Low, and O’Dea (2013)

Productivity is key

The saving and spending habits of younger workers and families since the onset of the recent UK recession, indicate they envisage their living standards to continue to stagnate.

We can expect the pattern of lower real wages to continue, but with fairly buoyant employment due to increased supply. Most falls in real earnings have happened, but with low growth and fiscal contraction, those relying on benefit incomes and tax credits will see their incomes decline.

It also appears the number of routine jobs near the middle of the earnings distribution has declined steadily. More jobs are now professional or managerial. In the late 90s to early 2000s, wages grew fast for high (and mid-skilled) occupations, but this slowed down around 2003 and real wages fell since 2009. This suggests longer-term earnings growth will mostly come from high-skilled occupations, with some at the very bottom. Productivity remains the key.

What is the implication for living standards? With little wage progression and low productivity for the low skilled, we have argued that incomes at the bottom will very likely only be maintained through increases in family labour supply and through the benefit and tax-credit system.

In policy terms there is much to be done around older workers in general, on the return to work for parents/mothers, and on entry into work among those leaving education. There are still some potential big gains here, among higher educated women age in the workforce for example. As argued in the Mirrlees Review (2011), the tax and welfare system can be better designed to enhance earnings and reduce unnecessary inequalities.

It would make sense to focus incentives on transitions in to work and on the return to work for mothers with young children, whilst enhancing incentives among older workers.

At the same time, there is a need to address top income inequality by better aligning tax rates across different forms of remuneration, removing unjustified tax expenditures and reforming the taxation of housing and capital transfers. Again the Mirrlees Review (2011) provides a blueprint for reform.